Startup investing has become quite popular today thanks to the increase of investment opportunities offered via equity crowdfunding platforms. But as compared to investing in the stock market or other more mainstream vehicles, investing in startups has some unique features.
In this article, we will mention five things private investors should be aware of before committing any capital to support startups and participate in future capital appreciation. These are things you should know and/or think about before deciding if private investing is right for you.
1. Startup Failure Rates Are High
It may feel like something everyone already knows, but this isn’t the safest place to park your money. A recent report on Review 42 about startup failure rates in 2020 shows that investing in startups is very risky. Here are some statistics you should know:
“90% of new startups fail.
“75% of venture-backed startups fail.
“Under 50% of businesses make it to their fifth year.
“33% of startups make it to the 10-year mark.
“Only 40% of startups turn a profit.
“82% of businesses that fail do so because of cash flow problems.
“The highest failure rate occurs in the information industry (63%)”
This doesn’t mean you should never step into the private investing realm, but you need to be sure it’s right for you first. What is your risk tolerance? Are you going to be in trouble if you lose the money you plan to invest?
2. The Market Potential and its Dynamics
Investing is a dynamic process that starts from the core of the business opportunity — the market itself.
Imagine a pair of scenarios where a startup that interests you could potentially gain 1% of the market share. The first scenario is that the market is valued at $1 billion. The second scenario is that the market is valued at $1 trillion. Which scenario makes investing in this startup more appealing?
I think we all know the fundamentals support the second scenario.
Like in publicly traded companies, the first fundamental metric to look at is revenue. But it is always a good idea to examine and analyze the market dynamics, trends, technological innovations and legislation developments. And last but not least, take some time to look at the competition. Is the company entering a crowded field or is it a first mover in a disruptive niche?
Luckily most of this information is offered by the startups in their pitch decks.
3. The Cash Burn Rate
The cash burn rate is very important because it can predict the degree of financial existence of the startups.
The Corporate Finance Institute defines burn rate as “the rate at which a company depletes its cash pool in a loss-generating scenario. It is a common metric of performance and valuation for companies, including start-ups. A start-up is often unable to generate a positive net income in its early stages as it is focused on growing its customer base and improving its product.”
there is both a gross burn rate and a net burn rate. But let’s focus on the net burn rate here.
The net burn rate is the rate at which a company is losing money (and to be fair, losing money is typical for startups during their first years of business activities). The net burn rate is calculated by subtracting its operating expenses from its revenue. It’s a measure of negative cash flow. Negative cash flows are a red flag in investing, as they can lead to bankruptcy. So a very high net burn rate is alarming.
A more straightforward calculation for net burn rate is to divide cash by monthly operating losses. This calculation will theoretically give the number of months a startup can survive, and the higher that number is, the more time the company may have to attain future profitability. If you have to choose between two startups with different net burn ratios, the one that burns cash at a slower pace is much safer than the other one.
Yes as in public companies, cash is king.
4. The Management Team and their Vision, Passion
Successful business stories are made by people — their visions, their abilities and their passion. It is not unusual for public companies to witness a dramatic turnaround based on the change of their CEO.
In private investing, perhaps even more importance should be placed on the founders and the management teams. While their history can’t exactly predict future success, investing time to read the profiles of the founders, any of their previous business projects, interviews or their values and passion shown on their social media accounts is time well spent. A team that has the vision to make a difference and disrupt the standards in an industry may offer notable investment returns.
5. The Exit Strategy from Startup Investing
On the equity crowdfunding platforms, one of the best features for investors is the transparency about financial statements and terms of the investment opportunities.
What is the time horizon for the startup to go public, or to be sold to another company? What are the options and scenarios? The schedule for the future IPO? What will happen if the fundraising goals are not reached?
Illiquidity in private investing is one of the most important risks to consider. A clear exit strategy should be presented and analyzed by investors. If the IPO is scheduled three years from now, are you willing to be patient and wait that long for any returns?
In conclusion, these five things should be considered for private investing decisions. As a bonus a sixth factor to be aware of is a study on ScienceDirect that shows the following interesting facts:
“Innovativeness is negatively associated with startups’ subsequent survival.
“An ex-ante measure of innovativeness reveals the negative association.
“Entrepreneurs’ greater appetite for risk magnifies the association.”
Innovation in startups can make investments challenging but the report mentions that “Pursuing innovations entails a more complex start-up process.”
Private investing is risky, and with innovation, it gets more complicated.
As of this writing, Stavros Georgiadis did not hold a position in any of the aforementioned securities.
Investing through equity and real estate crowdfunding or asset tokenization requires a high degree of risk tolerance. Despite what individual companies may promise, there’s always the chance of losing a portion, or the entirety, of your investment. These risks include:
1) Greater chance of failure
2) Risk of fraudulent activity
3) Lack of liquidity
4) Economic downturns
5) Dearth of investor education
Read more: Private Investing Risks